Nice little uptick at the end of the day though. In other words, I think we’re all gonna be ok.
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I don’t really see how a metric like this that doesn’t include prevailing interest rates can be all that helpful. The 10 yr treasury in 2000 was yielding 6%. In 1980 it was 11%. Today it is 2.75%.
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So that implies like 40-50% downside.
I get where this comes from but this to me seems kind of like opening a GTO range/sizing at a live mid stakes poker table.
On the other hand if everyone is making the “standard” decisions between bonds and stocks, then as the rate moves up/down everyone is going to be buying and selling the same ratios of the same assets, and moving prices accordingly.
Thus, if the rate environment can be predicted, which seems reasonable, these things should normalize based on long-term expectations.
Like people kept telling me these really high valuations were actually quite sensible given the rate being at/near zero. I was like, “OK, but do you expect the rate to stay at/near zero forever?” And of course the answer is no. “Well then, shouldn’t they be worth less?” And the answer is, well they might be when the rate drops.
That’s like seeing a businessman in a suit with a scotch in his hand sit down at the poker table and playing GTO against him until he proves he’s going to play suboptimally.
Essentially what Buffett is saying IMO is that over the long run, that ratio is going to trend towards say 90-110% and it provides good guidance on whether to be overweight or underweight on stocks.
Nothing to do with bonds vs stocks. The valuation of stocks contains the risk free rate in the denominator (among other rates like equity risk premium).
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Yes I know, my point is that if the market knows that rate is not going to persist forever, then it should be priced as such.
As a thought experiment, right now the Fed rate is 0.75% to 1%. Let’s say the Fed announced that they were going to drop it to 0% for six months, then raise it back to 1.5%, and slowly raise it to 2.5%. Would it make sense for stocks to rip back to all time highs for six months, then crash? I think we can all agree that’s not the case.
Obviously that’s an extreme, but rates being temporarily low shouldn’t lead to crazy high stock valuations, and rates permanently being at zero should never have been priced in. It’s pretty crazy they stayed low for as long as they did, which caused a lot of this.
I don’t think I’m smarter than the market, so I don’t have any sort of opinion outside of the market for what the long term risk free rate ‘should be’ or which direction it is going. In 1980 the 30 year treasury was yielding 14% and today it’s yielding 2.75%. If you think stocks should trade at comparable ratios of cash flows (or GDP as a proxy for cash flows) regardless of this fact then your view of valuations is interesting.
What risk free rate do you use in your discounted cash flow model? How do you adjust it?
The graph is interesting and compelling to some extent, but did the people who use this as a guide for investment decisions start shorting the market in 2015 in anticipation of a big crash?
If you use Buffett as a guide, he seems to have just gone pretty underweight on equities.
Yeah that was always my rationale for staying in. The market seems crazy, but it could always get a lot crazier you miss the boat. And if you pull out when it’s high, well you’re just trying to time the market. And you probably would have pulled out way before the real run up.
That said I’m really wishing when I cashed out my oil stonks, I just put the money into BRK.B like I said I would, instead of doubling down on cruise lines. That one hurts. I got greedy. (I do still most of my portfolio in index funds. And I specifically picked a lot of value indexes and international indexes for times like this.)
But if you look at the entire market the way I looked at TSLA once it started going crazy - not a believer = not gonna touch it no matter how high it goes, then I guess you’ve been sitting out for a while.
I would have been buying everything I could get my hands on from the mid 1970s to the mid 1980s most likely. Obviously over the last several years I’ve been conservative and selective.
I think anyone who expected the 30 year treasury to stay at 14% forever was just being willfully ignorant of how this stuff works, and anyone basing their valuations on the current rate instead of a range of forecast rates over the next decade or so is making a mistake.
My valuations are based on balance sheet/financial strength, earnings history, and dividend/buyback yields. In comparing current/future earnings, I use the AAA Bond Yield.
Suppose I were selling a magical box that generates a yearly dividend in perpetuity with the following attributes:
- In year 1 it will generate an expected dividend of $1 with standard deviation of 20c.
- Its annual change in dividend is expected to increase by 1% of the prior year’s dividend with standard deviation of 20% of the prior year’s dividend.
I’m going to auction this magical box. How would you determine what you were willing to bid for the box? How much would the 30 year Treasury being at 3% vs 14% impact your price?
I’d be very unlikely to win an auction on an asset like that, because I’d bid extremely low based on the description you provided.
Yes but way less than it would probably impact your price. I would not expect a 14% rate to hold. I’d expect it to move towards the historical average of 4 to 5%.
Like, the rate goes up, stocks go down. The rate goes down, stocks go up. Over any 15-20 year period the rate has moved towards the historical average of 4 to 5%.
$3.50
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How much would you bid?
I’d have to see stock prices to make a comparison to those. I’m guessing in the early to mid 80’s I’d be almost entirely in stocks and expect big returns so I’d probably bid something like $4 for an expected annual dividend yield of $1. It’s possible I wouldn’t even bid, though, because the variance on that might be higher than on stocks in my estimation.
If I was partially in bonds at a 14% yield, then obviously I’d be willing to bid more and move out of bonds.
How much would you bid in 2022?
Not an expert here by any means but either you or I have this backward. If risk-free return is higher, return for the alternative must be higher to justify choosing it, which means price must be lower in this scenario.
Right, I was basing it on $1 dividend. With the 20c standard deviation there’s a 95% chance it’s between 60c and $1.40, so maybe we bid based on 60c if we’re comparing to bonds and go for like $4.20.
Before I bought I-bonds or before my next round, head to head with those I’d pay at least $4.00 for it assuming it was equally liquid (or better). I’d have to do some research and think a bit more about the math problem.
In my IRA right now, based on some quick back of the napkin math, I would bid like $3 for it or something like that and probably wouldn’t win. A few weeks ago I probably would have bid more, but I think having dry powder in the likely event the market keeps dropping is more valuable than buying something like this.
If I were just an index investor and I had reasonable assurances of the liquidity, I’d probably bid like $7.50 or something.